چکیده انگلیسی

How costly is the poor governance of market intermediaries? Using unique trade level data from the stock market in Pakistan, we find that when brokers trade on their own behalf, they earn annual rates of return that are 50-90 percentage points higher than those earned by outside investors. Neither market timing nor liquidity provision by brokers can explain this profitability differential. Instead we find compelling evidence for a specific trade-based “pump and dump” price manipulation scheme: When prices are low, colluding brokers trade amongst themselves to artificially raise prices and attract positive-feedback traders. Once prices have risen, the former exit leaving the latter to suffer the ensuing price fall. Conservative estimates suggest these manipulation rents can account for almost a half of total broker earnings. These large rents may explain why market reforms are hard to implement and emerging equity markets often remain marginal with few outsiders investing and little capital raised.

مقدمه انگلیسی

The governance of equity market intermediaries through the appropriate design and enforcement of law and regulation particularly in emerging markets has received increased emphasis recently (see Glaeser et al., 2001 and La Porta et al., 2003). A belief is growing that emerging markets need improvements in their legal and institutional environment to develop. For example, Glaeser, Johnson, and Shleifer argue that self-regulation by brokers in emerging economies with costly law enforcement is unlikely to be successful. However, despite such concerns, little is known about the costs of misgovernance among market intermediaries. Poor regulation and weak enforcement of law lead to what kind of undesirable outcomes? What behavior of market intermediaries should regulation curb? What are the costs when legal and regulatory checks fail? This paper answers these questions by an in-depth analysis of broker behavior in an emerging stock market.
We identify brokers in the stock market who manipulate prices to their own advantage and at the expense of the outside investor. These brokers engage in frequent and strange trading patterns indicative of the anecdotally familiar “pump and dump” manipulation schemes. We show that these schemes result in substantial gains of 50 to 90 percentage points higher annual returns than the average outside investor. These large rents not only explain why many potential rational investors choose to stay out of the equity market, but also from a political economy perspective help provide an understanding of why entrenched players so often actively resist efforts to institute reforms. If such manipulation and its magnitude are substantial, then the results of this paper would add to an understanding of why equity markets fail to develop in many poor economies.1
The manipulation activity identified in this paper is likely to be prevalent among other emerging markets. Numerous accounts of emerging markets today show similar concerns. Khanna and Sunder (1999), in a case study of the Indian stock market, states that “brokers were also often accused of collaborating with company owners to rig share-prices in pump-and-dump schemes”. Zhou and Mei (2003) argue that manipulation is rampant in many emerging markets where regulations are weak and note that China's worst stock market crime in 2002 was a scheme by seven people accused of using brokerage accounts to manipulate company share prices.
Moreover, historical accounts of mature financial markets suggest that such manipulation is a common hurdle that young markets have to overcome. For example, the Amsterdam stock exchange in the 1700s and the New York Stock Exchange in the 1900s (Gordon, 2000) show a wide concern for the prevalence of price manipulation in these markets. The stated justification for the U.S. Securities Exchange Act of 1934 was to eliminate manipulation resulting from stock pools, whereby groups of traders jointly trade in a particular stock to manipulate prices.
While anecdotes abound, the lack of suitable data has made it difficult to test for these stories. This paper, to our knowledge, offers one of the first attempts at doing so by exploiting a unique trade-level data set. The data set contains all daily trades of each broker in every stock trading during a two and a half year period on the Karachi Stock Exchange (KSE) the main stock exchange in Pakistan. The micro nature of this data set allows us not only to test for a specific price manipulation mechanism, but also estimate the returns from manipulation activities in general.
Because anecdotal evidence suggests that market intermediaries (brokers) run manipulative schemes, the paper starts by differentiating between trades done by a broker on his own behalf and those done on behalf of the outside investor. Given this separation, we find that when brokers trade on their own behalf (act as principals) they earn at least 50 to 90 percentage points higher annual returns over, and at the expense of, outside investors.
We then test directly for some possible means of manipulation. While several mechanisms of market manipulation could exist, anecdotal evidence and cyclical trading patterns suggest a particular one. When prices are low, colluding brokers trade amongst themselves to artificially raise prices and attract naive positive-feedback traders. Once prices have risen, the former exit, leaving the latter to suffer the ensuing price fall. While this mechanism is stylized, we find compelling evidence for it. First, on days when the stock price is relatively low, principal brokers trade amongst themselves, i.e., most of the trade (both buys and sells) is done by brokers who act as principal traders in the stock. Conversely, on high price days, most trade is done by outside traders, i.e., principal traders are out of the market. Second, trading patterns of principal brokers have strong predictive power for future returns. Periods when principal brokers buy and sell stocks only to each other lead to positive returns. Such within principal broker trading cannot, by definition, affect the profitability differential because it captures the difference in profits between principal brokers and outside investors. Moreover, there is no reason to suspect that this relationship is spurious and not causal (such trades and the future positive returns are both caused by some unobserved real factor). If this were the case, one would expect the more informed, principal brokers to be either buying or selling but not doing both back and forth. Third, further evidence that this relationship reflects manipulation is that the price increase from back and forth principal broker trading appears artificial. Prices collapse once the principal brokers exit the market (the absence of principal brokers in the market predicts negative returns).
Whereas these tests provide compelling evidence for the presence of price manipulation, one could argue that the profitability differential could also arise for reasons other than price manipulation. Two broad classes of alternative explanations are that (1) brokers are better at market timing because of front running or access to private information and (2) brokers are market makers (earn rents for liquidity provision services). However, we show through a series of tests that these cannot be sufficient explanations for the profitability result. For example, the profitability of high-frequency cyclical trades is hard to reconcile with market timing in any realistic informational environment. Similarly, inclusion of broker attributes or liquidity measures fails to account for the profitability differential.
Natural reasons exist to expect that brokers have a comparative advantage in engaging in manipulation activities. They have lower transaction costs in conducting the frequent trades that could be necessary to generate momentum in a stock. They have better real-time information about the movement in prices, volumes, and traders’ expectations, and they possess a natural advantage in spreading rumors or false information in the market. All these factors are crucial to the success of a manipulation strategy.
Finally, our calculations suggest that such manipulation rents are large in absolute terms. Conservative estimates reveal a $100 million (Rs 6 billion) a year transfer of wealth from outside investors to principal, manipulating brokers, which is around 10% of market capitalization. In a country with per capita gross domestic product (GDP) at $450, this is a significant wealth transfer. Moreover, estimates suggest that this is significant relative to the total earnings of brokers (including estimated brokerage commissions), accounting for 44%44% of these earnings.
Our paper is related more broadly to the literature on institutions defined as the appropriate design and enforcement of law, contracts, property rights, and regulation. This literature has taken a central stage in the discussion of financial and economic development. Examples include a series of theoretical papers motivated by cross-country comparisons such as Acemoglu et al., 2001 and Acemoglu et al., 2002, Acemoglu and Johnson (2003), La Porta et al., 1997, La Porta et al., 1998, La Porta et al., 2000 and La Porta et al., 2002, and Shleifer and Wolfenson (2002). This theoretical interest has coincided with recent micro-empirical work that has attempted to identify channels through which weak institutions lead to corporate and financial inefficiencies (Johnson and Mitton, 2003, Fisman, 2001, Bertrand et al., 2002 and Boone et al., 2000). These papers identify weak shareholder protection and crony capitalism as important forces contributing to the loss of minority and unconnected shareholder wealth.
However, while the theoretical literature emphasize the importance of institutions more broadly, the micro empirical work has primarily focused on corporate governance issues related to firm management. Thus an important complement that has remained unexplored, and that this paper tries to address, is the governance failure associated with the regulation of market intermediaries.
Our work is also related to the work of Morck et al. (2000) who show that stock prices in emerging markets are more synchronous. The collusive manipulation of stock prices to attract outside investors could be one explanation for this finding. Similarly, the particular manipulation mechanism that show in this paper is related to the literature in behavioral finance that examines how (irrational) positive-feedback investment strategies can lead to inefficiencies in equity markets (De Long et al., 1990b and Shleifer, 2000). In this direction, our paper provides evidence in a real-world setting that outside investors trade using positive-feedback investment strategies. While we do not feel we have to take a strong stance on whether such feedback trading is rational or not, the data suggest that such momentum trading by itself is not profitable.
Because evidence shows that the mature markets of today suffered similar episodes of manipulation in their early years, perhaps emerging equity markets can also overcome these difficulties by adopting similar measures that, for example, the U.S. Securities and Exchange Commission (SEC) took to curb such manipulative behavior. We briefly discuss some possible measures in the conclusion.
The rest of the paper is organized as follows. Section 2 provides relevant institutional background and describes the data. Section 3 examines broker trading behavior patterns, and Section 4 estimates the excess return that brokers who trade on their own behalf (principal brokers) earn compared with the average outside investor. Section 5 then tests for a specific trade-based price manipulation mechanism, Section 6 considers alternate explanations, and Section 7 concludes.

نتیجه گیری انگلیسی

This paper uncovers unusual trading patterns and systematic profitability differences arising from trades between brokers and outside investors in emerging markets. While market-timing and liquidity-based explanations could account for some of the results, we argue that the evidence is indicative of manipulation of stock prices by collusive brokers.
How significant are these manipulation-based rents, particularly in relation to what brokers earn by trading honestly (by intermediating for outside investors)? While it is hard to come up with precise numbers, we can provide estimates by making assumptions about trading behavior and brokerage commissions. Specifically, we assume that a fraction PRIN of a broker's trades in a given stock are manipulative and a fraction 1-PRIN1-PRIN are intermediary trades. We can then arrive at estimates of earnings by using a 50% return on the manipulative trades (a conservative estimate of the PRINPRIN effect) and a 1% brokerage commission (the average commission rate in the KSE) on intermediary trades. The former gives us what the broker earns from manipulation in a given stock and the latter his earnings (total brokerage commission) from honest trading in the stock. 21 We can then compute a broker's total manipulation and honest trading earnings by summing the respective numbers across all the stocks he trades in.
Doing so reveals a couple of findings. First, manipulation rents are a significant part of the overall market: 44% of total broker earnings in the market.22 Moreover, these rents are likely to be an underestimate. Second, examining the earnings from honest and manipulative activity for each broker reveals that most brokers are earning significant manipulation rents. Fig. 7 gives the distribution of the share broker's earn through manipulation and shows that most brokers are clustered around the single mode (40%). This in turn has implications for regulation because it implies that instead of focusing only on a few brokers, regulation must correct for the presence and extent of manipulation in general.
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Fig. 7.
Manipulation rents as a percentage of total broker earnings. Total broker earnings are made up of manipulation rents computed using a 50% return on trading done by broker on their own behalf (our conservative estimate in the paper) and brokerage commissions computed using a 1% commission rate on the value of trading done by a broker on behalf of outsiders.
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The broader question then raised by our results is how important are the market inefficiencies, identified in this paper, from a country's financial development perspective? Our view is that, in terms of direct costs, the large transfer of wealth from outsiders to insider manipulators is likely to significantly discourage how much and how many outside investors choose to invest in the market. The presence of manipulators and naive traders imposes large participation costs for rational and sophisticated agents trying to either invest or raise capital in equity markets. Such participation costs form an important piece in solving the puzzle of financial underdevelopment. If manipulation becomes more difficult as the number of players and the size of the market increases, then there is a possibility of multiple equilibria: one with excessive manipulation and a small market size, and another with little or no manipulation and a large market size. Furthermore, the manipulation activity we show can be responsible for excessive volatility in the market and in turn impose additional participation costs.
An important agenda for future research is to understand and show what additional mechanisms used by market intermediaries could increase the participation costs and lead to excessive volatility in these markets, as discussed by Kindleberger (1978) in his seminal work Manias, Panics, and Crashes. Such work leads to a better understanding of what reforms are successful in limiting the misgovernance of markets by intermediaries. Such reforms could include a greater presence of independent members (nonbrokers) in the exchange's board of directors; facilitating entry and competition amongst brokers, including the setting up of new exchanges; better systems of surveillance; tighter enforcement of existing and new regulation, such as stricter margin and capital adequacy; and information disclosure requirements that protect outside investors and prevent undesirable activities in the market.
Our results also suggest that, to the extent that a significant part of the market turnover reflects such manipulative practices, increased market turnover is unlikely to either lead or even reflect overall growth in the economy. Thus, in trying to find positive correlations between market turnover and growth using cross-country data (e.g. Levine and Zervos, 1998), emerging economies such as Pakistan (and Fig. 1 suggests there could be several others) appear as outliers. However, we should be careful in drawing inferences. Our results do not imply that financial markets have little to contribute to growth but that observing an active market should not automatically lead one to conclude that such a role is being played.
Identifying inefficiencies such as market manipulation and the resulting significant rents accruing to individuals can help begin to answer the more fundamental political economy question of why countries fail to adopt and implement good governance and other laws needed to strengthen equity markets. Even if it is obvious what reforms need to be taken to improve efficiency, because such reforms are likely to limit manipulation, they will be resisted by the conspiring brokers. This will be the case when, in the post-reform improved equilibrium, one cannot guarantee these brokers a large enough share of the pie, i.e., the Coase theorem no longer holds. This seems to be the case in Pakistan, where efforts by the SECP to initiate reforms have met with strong political opposition by lobbies working on the brokers’ behalf.
To conclude, because the rent-seeking activities identified in this paper are likely to occur in newer and shallower emerging markets, they can in turn be responsible for limiting the depth and size of such markets leaving them in infancy traps in the absence of a positive reform. The concern is that equity markets, whose job is to facilitate real economic activity, could remain as phantom markets that serve little economic purpose.